When Analysts Sober Up

Between the government shutdown and the budgetary brouhaha, surely Wall Street analysts have been racing to reduce their forecasts of companies’ earnings for the fourth quarter.

Surely you jest.

“We’re not seeing more cutting of forecasts than normal,” says John Butters, a senior earnings analyst at FactSet. “If anything, it’s been below average.”

That sluggish reaction is a reminder that analysts are glued as tightly to the companies they cover as barnacles are to the bottom of a ship. And it holds lessons for all investors about how humans manage their expectations to minimize disappointment.

Between Sept. 30 and Oct. 10, the sum of fourth-quarter earnings-per-share estimates for companies in the S&P 500 fell by 0.14%, according to FactSet. Over the past decade, the average decline in earnings forecasts over the first 10 days of a quarter was 0.32%. So “the analysts are in a wait-and-see mode,” Mr. Butters says.

What are they waiting for?

In each quarterly earnings announcement and the associated conference call, chief executives and chief financial officers discuss the results as well as their expectations for the quarter and year to come. It is that forward “guidance” that will get the analysts to move.

And they will move down. Every year like clockwork, analysts start out bizarrely optimistic about future results, then “walk down” their forecasts as the actual earnings announcement draws closer.

The greater the uncertainty, the longer the wait until the final collision with reality—and the bigger the relief that investors feel, as we saw this past week when the market shot up on a temporary budgetary deal in Washington.

Deliberately managing expectations downward in conjunction with the company is an artificial kind of surprise. But the result makes everybody happy—at least in the short run.

Consider Apple. according to Thomson Reuters, in July 2012, analysts expected the company to earn $12 a share for the quarter that would end June 30, 2013. By mid-April this year, the forecast had fallen to $9.04.

On April 23, Apple’s management, in “negative guidance,” signaled slowing revenue growth. The analysts promptly dropped their average forecast to $7.40. By July 23, when Apple reported results for the June quarter, analysts were expecting earnings of just $7.32 a share.

The analysts had gone from being overoptimistic to overpessimistic. After Apple announced $7.47 in earnings that day, the stock shot up 11% over the next two weeks.

“Analysts always tend to be more optimistic when they’re looking far ahead,” says Greg Harrison, a senior analyst at Thomson Reuters. “They don’t see the latest negative news as affecting the company that far out.” Then, around 90 days before the earnings announcement, analysts cut their forecasts in a collective rush.

Next, Mr. Harrison says, “as the [final announcement] approaches, reality sets in” and analysts cut their estimates again—often to a level below the final number the company will report.

Such farcical behavior is part of human nature. You probably think you are less likely to get cancer, be divorced or fail in your career than the average person will. So does just about everybody else, and we can’t all be right.

But optimism comes with a twist: Rose-colored glasses work more powerfully at a distance.

People tend to be highly optimistic when thinking about outcomes far in the future, but they scale back their expectations as the moment of truth draws near. Kate Sweeny, a psychology professor at the University of California, Riverside, calls this phenomenon “sobering up.”

A year in advance, Prof. Sweeny says, “you have a lot of time ahead of you before your prediction can be disproved, so your motivation to fix it is lower.” Furthermore, as the final outcome approaches “you go from thinking about it in abstract terms to more concrete, nitty-gritty detail.” That shift leads peopleto lower their expectations, she says, “so you can feel great if you’re pleasantly surprised.”

Investors should, then, take little comfort from the fact that analysts haven’t yet reduced their earnings forecasts for the coming quarter or taken the government shutdown into account.

“They still have plenty of time to get those fantasy numbers down,” says James A. Bianco, president of Bianco Research in Chicago. Also, Mr. Bianco jokes, “CFOs are giddy that they don’t have to blame it on the weather this time.”

The government shutdown, he says, “is the new weather”—a flexible pretext that can be trotted out to sober up any analyst who hasn’t yet ratcheted a forecast far enough downward.

Nor should you assume that the cynical deferral of bad news is bound to crush the market when it finally hits home.

By sobering up on negative guidance over the next couple of weeks, analysts could enable companies to beat lowered expectations. That would orchestrate a “surprise” that could reinvigorate the aging bull market—until, of course, a real surprise comes out of nowhere.